Retirement withdrawal rates and the market

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D.
program in financial services and retirement planning at The American College in
Bryn Mawr, PA. He is also a principal and director at McLean Asset Management,
helping to build model investment portfolios which can be integrated into
comprehensive retirement income strategies. He actively blogs at
RetirementResearcher.com. See his
Google+
profile for contact information.

Classic safe withdrawal rates studies, such as the works of William Bengen and the Trinity study, investigate sustainable withdrawal rates from rolling periods of the historical data, which give us an idea about what would have worked in the past.

For a 30-year retirement period, we can learn about the historical sustainable withdrawal rates beginning up to 30 years ago. To make sure this is clear, we won't know what the sustainable withdrawal rate for someone retiring in 2000 will be until the end of 2029. The question remains as to whether those past outcomes provide sufficient insight about what can reasonably be expected to work for post-1980 retirees.

The general problem with attempting to gain insights from the historical outcomes is that future market returns and withdrawal rate outcomes are connected to the current values of the sources for market returns. Future stock returns depend on dividend income, growth of the underlying earnings, and changes in the valuation multiples placed on those earnings.

If the current dividend yield is below its historical average, then future stock returns will also tend to be lower. When price-earnings multiples are high, markets tend to exhibit mean reversion and relatively lower future returns should be expected.

Returns on bonds, meanwhile, depend on the initial bond yield and on subsequent yield changes. Low bond yields will tend to translate into lower returns due to less income and the heightened interest rate risk associated with capital losses if interest rates rise.

Sustainable withdrawal rates are intricately related to the returns provided by the underlying investment portfolio. With sequence of returns risk, the returns experienced in early retirement will weigh disproportionately on the final outcome. Current market conditions are much more relevant than historical averages. Though the Trinity study is quite popular with retirees, past historical success rates are not really the type of information that current and prospective retirees need for making their withdrawal rate decisions.

This is of much more than just an academic interest, as in the past 15 years, we first experienced unprecedented highs for stock market valuation levels, and then unprecedented lows for dividend yields and bond yields. With unprecedented market conditions, the past may not serve as prologue. Today, I wish to focus on the case of stock market valuation levels.

For Yale University Professor Robert Shiller's cyclically-adjusted price-earnings ratio (PE10), the highest value in a January before 1980 was 27.1, which happened in 1929. That was the year of the stock market crash leading to the Great Depression. Since 1980, though, PE10 was above 27.1 in 8 years, including 1997-2002, 2004, and 2007. A highpoint of 43.8 occurred in January 2000, which is 62% higher than its pre-1980 high.

An alternative way to look at the historical data is to consider not just the past withdrawal rate outcomes, but rather to consider how past withdrawal rates related to the retirement date values of the underlying sources of returns. We can find a way to investigate these implications by following the approach described in 1998 by John Campbell of Harvard University and Robert Shiller. They estimated the relationship between PE10 and the subsequent 10-year real return for stocks, and they found some useful predictive power. Returns tend to be lower after high valuation periods and vice versa.

Sustainable withdrawal rates from a diversified portfolio including stocks can also be expected to share this relationship with market valuations. The person deserving credit for first quantifying the nature of this relationship is John Greaney, who wrote at an early retirement online message board in 2002 that:

I'm not aware of anyone who has been successful in timing when stock prices are high or low over the long-term. If you possess this unique ability that others lack, perhaps the easiest thing to do is to adjust the safe withdrawal rate by the amount that you consider stocks to be higher than they have ever been. If stocks are 25% higher, drop the 4% withdrawal to 3%. If you feel stocks are 50% higher than they have ever been, then drop the 4% down to a 2% withdrawal.

It does turn out that retirement date market valuation levels explain the subsequent sustainable withdrawal rates pretty well, and when you extrapolate this out, it suggests that the sustainable withdrawal rate for retirees in 2000 could be much closer to 2% than to the 4% safe withdrawal rate rule-of-thumb.

This sounds like awfully bad news, but it is important to emphasize that as we have never experienced such high valuation multiples at a time when we know what the subsequent sustainable withdrawal rate is, we have to be cautious about the interpretation. These analytical models can be notoriously bad at forecasting outside of the range of historical experience, which is what we are asking the model to do in the case for a 2000 retiree. The range of possible outcomes is quite wide, and it is possible that 4% could still work out. This may be why John Greaney rejected this approach immediately upon describing it, but I think his concerns about market timing are going too far.

This is a case where greater conservatism, as suggested through the use of a lower withdrawal rate, could be warranted for a risk averse retiree. The real lesson for me is that using a 4% withdrawal rate from a portfolio of risky assets is not as safe as the historical outcomes would lead us to believe. Flexibility and vigilance are advised.

Nevertheless, the news should not be all bad for someone who stayed the course with their retirement planning strategy and did not cash out, stop saving, or retire early as the bull market raged in the late 1990s.

In my article on "safe savings rates," which won a prize as the most influential article from 2011 in the Journal of Financial Planning, I argued that someone saving with a consistent strategy and then retiring at the start of 2000 could have achieved their retirement spending goals with a 2.6% withdrawal rate.

I think we must pay more attention to the pre-retirement savings period, rather than just worrying about a one-size-fits-all safe withdrawal rate.

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